Inflation May be Inevitable...

Among the factors for determining future allocation decisions is the most likely direction for inflation. We have noticed a number of investment firms launching new funds to profit from the inevitable return of high prices. Many of these product managers assume that increasing demand and dwindling supply of crude oil and industrial metals will result in pricier finished goods, and that consumers will eventually adjust to such conditions, as they did in the 1970s.

In our view, these new products are coming far too early. The U.S. economy has more immediate issues to deal with. Although housing prices have begun to rebound, a large inventory of foreclosures will likely swamp the market in the fourth quarter. Apartment vacancy rates have risen, resulting in net effective rents falling about 3%. These two metrics make up about 30% of the consumer price index, a key gauge for inflation.

Consumer confidence is also suffering, mainly due to concerns about job security. Historical spending patterns are not likely to return soon, as families are saving more money for an uncertain future.

Even in this backdrop, we see significant pockets of opportunity in the markets. The corporate fixed-income market remains attractive, with yields that approach the long-run return of stocks. International bonds offer tempting yields as well, with the additional benefit of foreign currency exposure. And both foreign and domestic large-cap equities are still modestly attractive, even considering the large run-up in prices seen since the March’s lows.